Capital Account Convertibility

The government has clarified that it is not looking at full capital account convertibility for the next few years.

 
Background:
Raghuram Rajan, the previous Reserve Bank of India governor, had said that the central bank was looking at bringing in capital account convertibility in a few years. However, the debate has acquired a new dimension with the International Monetary Fund (IMF) recently becoming more cautious about its benefits for developing economies.
 
What are capital controls?
Capital controls are used by the state to protect the economy from potential shocks caused by unpredictable capital flows.
 
What does capital account convertibility mean?
Essentially, it means freedom to convert local financial assets into foreign ones at market-determined exchange rates.
 
What can it do?
It can lead to free exchange of currency at lower rates. Also, it can result in unrestricted mobility of capital.
 
How does it benefit a nation?
It can trigger stepped up inflow of foreign investment. Transactions also can become much easier, and occur at a faster pace.
 
What are the negatives?
It could destabilise an economy especially if there is massive capital flows in and out of the country. Currency appreciation/depreciation could affect the balance of trade.
 
Where does India stand now?
India currently has full convertibility of the rupee in current accounts such as for exports and imports. However, India’s capital account convertibility is not full. There are ceilings on government and corporate debt, external commercial borrowings and equity.
 
 
What do you understand by Capital Account Convertibility (CAA)? There is a debate going on whether India should go for full CAA or for partial CAA. Examine the advantages and disadvantages of both full and partial CAA. Based on this examination, suggest whether India should go for full CAA or not. (200 Words)
 
Capital Account Convertibility (CCA) is the facet of a country’s financial system which allows for the conversion of foreign financial assets into domestic financial assets and vice versa at market determined rates. Such convertibility may be completely unrestricted or may be partially regulated.
 
This theory, to enable third world economies to grow as globalised economies, was proposed by the Tarapore Committee setup by the RBI.
 
Preconditions:
CAC shall be introduced in an economy only when there is low inflation, low fiscal deficit, low NPAs, high Forex Reserves, functional independence of the Central Bank, no restrictions on Gold movement.
 
 
The main advantages of full CCA are:
  1. It will help India deepen its market and help India attain the status of a leading global economy.
  2. Improved access to international financial markets and reduction in cost of capital.
  3. This will open Indian financial markets to global competition and would in the long run contribute to the development.
  4. This will ensure the availability of large funds to supplement domestic resources and thus promote economic growth.
 
On the downside:
  1. Full CCA can lead to erratic flow of foreign capital, which can lead to financial instability.
  2. In today’s globalised context, such close integration will open up the Indian economy to the global shocks like the 2008 financial crisis.
  3. Speculative activity can lead to capital flight from country as in case of some South East Asian economies during 1997-98
  4. Imposing control would become difficult in a globalised environment once CAC is introduced
 
 
It is clear that the advantages of full CAA are broadly beneficial. However, given the underdeveloped state of the Indian financial ecosystem to face volatility risks associated with full CAA, adoption of partial CAA is more prudent and practical. The advantage of this approach is that the government can by way of regulatory mechanism come to the economy’s rescue in turbulent times, while the economy enjoys the benefits associated with full CAA during the relatively calmer times. The downside of partial CAA is the speed and scale at which capital will flow into India. However, this is a small price to pay for ensuring some semblance of stability within the economy, while the institutional forces work to strengthen the framework
for subsequent introduction of full accountability.

 

 

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